Protection for companies
By Melvin J. Howard
Banks are pretty highly leveraged these days and that these risks of leverage must be controlled since the banks lie at the heart of the financial system. The way this leverage is controlled so that risk of collapse is not too high, is to set limits on leverage commensurate with the risks of the loans or investments any bank is making. This is what the Basel Capital Accord the Bank for International Settlements (the central bank of central bankers) in Basel, Switzerland is all about. These accords specify a certain amount of shareholder or equity capital or "safety net" (from a depositor’s perspective) that banks hold as a function of the riskyness of their loans or investments. Such a safety net sets a bound on leverage and provides protection for depositors and taxpayers who are ultimately on the hook for massive bank failure.
Introducing Credit Default Swaps aka Credit Derivatives.
A derivative on an underlying asset basically allows you to make a bet on the future price of that underlying asset by betting just a fraction of the cost of that asset. The leverage comes about because the instrument basically replicates borrowing or lending of the underlying asset, without you ever having to physically own it.
Derivatives can help you manage risk if you already trade in the underlying asset. Let's say you are wheat farmer worried about wheat prices. Then derivatives can be used to buy insurance on wheat prices. Say if wheat prices go down, you can get compensated for your loss by buying insurance in the form of something called a futures contract or even a a "put option" on wheat. Your outlay for this protection is fixed - the cost of the insurance premium - but it has removed the potentially larger loss of plummeting prices.
However, like all such things with a good use, there is a large downside. That is that the leverage and potential returns available on derivatives attract speculators from all over the globe to play and to become major dealers in this market. This includes all Private Equity and Hedge Funds both domestic and international, capitalized by wealthy investors and then often also borrowing many multiples of this capital from federally insured banks. With this leveraged capital base they then enter into the highly leveraged and potentially lucrative world of derivatives. In addition the huge hundreds-of-trillions-sized market known as the Over-The-Counter (or OTC) derivatives market.
Until recently the credit default swap market, was the newest, hottest game on the block. This enables institutions that lend money to high credit risks to buy insurance on those risks.
For example, a bank with high loan exposures to certain lenders can pay a premium to a third party for a credit default swap, a form of credit insurance, whereby the bank would get reimbursed by the credit swap seller if the borrower defaulted. The bank is thus able to take this credit risk off its balance sheet and thereby is no longer required to hold the regulated amount of equity capital, or "safety net", against the risky credit risk. This means that the bank can further increase its leverage. If the seller of the credit default swap is not a bank, and especially if it is one of the unregulated hedge funds, then there may be no capital requirements (safety nets, or leverage limits) on such credit exposures. Therefore through the use of credit default swaps the overall financial system safety net shrinks and leverage and associated risks of collapse are increased, as always to be borne by depositors and taxpayers if things get too out of hand.
Add to this the fact that banks and others in need of credit protection are entering into these swaps through off-balance sheet vehicles to remove the underlying transaction from their balance sheet. So it's very difficult to tell what's going on and where and what the real risks are.
Regulators would argue that private fund operators perform an important function by helping build the base of counter-parties for valid risk hedges at the other end, and by ironing out pricing anomalies. They argue the funds should not be regulated for fear that this will add friction to these functions and/or send them offshore I agree. The same people often argue that OTC derivatives also should not be regulated as they help ensure capital and risk gets allocated efficiently around the markets, which facilitates our economic prosperity I also agree with this argument as well. But these arguments always ignore the larger risks being added to the system as a whole. This market only works if counter parties honor their agreements. With the current market in decline more and more counter-parties are trying to get out of their contracts and agreements.
The purpose of any insurance is to pool risks so that each individual in the pool lowers their own risk of some crippling disaster for a small annual fee paid to the pool. That is what derivatives are essentially insurance. Many people in capitalist economies who argue for less government intervention in the market economy seem to overlook the fact that the government creates the infrastructure for the markets to function in the first place.
Without government created legal and judicial infrastructure, even the most basic contract would not be enforceable, except at gunpoint. Since our whole monetary and trade systems are built primarily on contracts of agreement (with occasional input from the public), modern markets would not exist, and economic development could not happen, without significant government intervention.
As noted by John Maynard Keynes in the 1920s, without government intervention in redistributing wealth in suitable amounts you step on to a spiral of increasing inequality. "Nothing can preserve the integrity of contract between individuals except a discretionary authority in the State to revise what has become intolerable. The powers of uninterrupted usury are too great. If the accretions of vested interest were to grow without mitigation for many generations, half the population would be no better than slaves to the other half. Those who insist that the State is in exactly the same position as the individual, will, if they have their way, render impossible the continuance of an individualist society, which depends for its existence on moderation." Don’t get me wrong I think this market idea was genius and a fan of it. I am also for less government especially in the derivative market. But if counter parties stop honoring their agreements the cry from the public will be too great for the government to ignore because financial and insurance institutions will start to go under causing a ripple effects on the economy at large like it is now. So my solution for this current problem is “Less government more Honor”.
